If the strength of the global syndicated loan market was measured on records alone, then it would be in a state of rude health. This month banks have underwritten the worldâs fourth-biggest loan, Australiaâs largest loan and one of the tobacco industryâs biggest debt financings. Yet some observers think they can see the meltdown of the global credit markets ahead.

As private equity firms face growing problems in financing leveraged buyouts amid pressure on leverage levels, covenants and pricing, the risky end of the loan market is encountering difficulties. But in other areas the mood is brighter.

In the investment grade market, this month’s deals include a $40bn (€29bn) loan backing London-listed mining company Rio Tinto’s takeover of Canadian rival Alcan, and a £9.2bn (€12.6bn) loan taken out by UK tobacco company Imperial Tobacco to back its £11bn acquisition of Spanish rival Altadis.

Bill Fish, global head of loans at Dresdner Kleinwort, believes much of the global loans market is in good shape. He said: “The investment grade market remains relatively untouched by problems in the US sub-prime and leveraged loans markets.”

Bankers said although leveraged loan volumes backing mergers and acquisitions had grown sharply over the past five years, from $37bn in 2002 to $187bn last year, their share of the M&A loan market had fallen, according to data provider Dealogic. Loans made to finance sponsor-backed acquisitions accounted for 43% of acquisition-related loans in Europe in 2003. Last year, that figure had fallen to 29%.

Buyouts as a percentage of all European M&A deals have remained relatively static at about 15%, hitting a high of 17% last year but running at 14% so far this year. As one banker said: “The M&A market is up sharply, whether you take the buyout sector into account or not.”

The leveraged loan market remains small compared with the investment-grade market and bankers said the investors and their attitudes were markedly different.

One head of loans at a US bank said: “The investment-grade market is the pure banking world where relationships are long term but in leveraged land the market is split between banks and institutional investors, whether hedge funds or debt funds.”

The problems facing the leveraged loan market have been well flagged. A report published by Close Brothers last September estimated that hedge funds and specialized debt funds were providing nearly three quarters of the money backing leveraged loans in Europe. It raised the question of how those investors would react in the event of a downturn in the economy.

In a report entitled When the Music Stops! BNP Paribas analysts said: “There is no knowing how hedge funds will react once default rates pick up. Their high-reward philosophy contrasts with the traditional relationship view of the lending banks.”

The head of loans said he put many of the problems in the leveraged finance market down to the types of institutions backing the loans. He said: “Institutional investors, keen to make quick money, respond more quickly to changes in the credit markets, which has affected the wider European market.”

Banks insist the long-term view they take on relationships with corporate clients means the investment-grade market is different. However, while conditions remain good for well-rated companies, bankers admitted big acquisitions could face difficulties in the loan syndication phase.

One banker said: “For investment-grade companies looking to finance takeovers towards or above €10bn ($14bn), there could be difficulties. You cannot bifurcate the leveraged loan and investment- grade markets completely and confidence has been knocked.”

One deal bankers believe could face scrutiny is Rio Tinto’s $40bn loan, the fourth-biggest in the history of the acquisition financing market, according to Dealogic. The mining company secured the loan from Deutsche Bank, Credit Suisse, Royal Bank of Scotland and Société Générale and plans to launch it into the sub-underwriting phase by the end of this month.

Rival bankers said the deal could stretch investor appetite, especially if credit markets continue to suffer, but bankers close to the deal said they had had strong reverse inquiry demand to invest in it.
Loan market participants remain divided on the future of the investment-grade market, though even the most pessimistic forecast a slowdown rather than a collapse.

A corporate loan banker said: “On one side people believe the jitters in the leveraged market will precipitate a general drift in pricing as investors become more cautious. On the other, some believe you will see a flight to quality as lenders clamor to lend to top-rated names.”

Another banker said the loan market had historically been resilient to market shocks. He said: “The market weathered event-driven shocks such as 9/11 and the Russian debt crisis. There is no reason why that should change now.”